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What is a 5/1 adjustable-rate mortgage?

Posted by  on May 07, 2014
 

Q: What do the slashed numbers mean on mortgage quotes for adjustable-rate loans? For example, I recently saw a loan listed as a "5/1" adjustable-rate mortgage. What does that mean?

A: Those numbers designate the time periods at which the rate on an adjustable-mortgage loan will reset, and therefore they are very important in determining the nature of an adjustable-rate mortgage (ARM).

For example, while a simple one-year ARM will reset every year, a 5/1 ARM will hold its initial rate for five years, and then reset every year thereafter. A structure which has been gaining popularity of late is a 5/5 ARM, which resets after five years and then again at each subsequent five-year period.

Longer reset periods make future payments more predictable. However, if predictability is what you want, in most cases you would be better off with a fixed-rate loan. The exception to this is if you expect to be able to pay the loan off early. In that case, you could benefit from the lower initial mortgage rates generally associated with ARMs, but still limit your exposure to rising rates by terminating the loan early.

The reason ARM rates are generally lower than fixed mortgage rates is that ARMs are less risky to mortgage lenders. By being able to reset rates periodically, lenders avoid the risk of being locked into substandard rates for a long time -- a risk that was an especially big concern when rates were at record lows.

From the borrower's standpoint, key considerations when evaluating whether to choose an ARM include:

  • Length of reset period
  • Reset limits
  • Initial rate discount compared to fixed-rate-mortgage loans
  • Likelihood of being able to repay the loan early
  • Penalty for early repayment

ARMs expose borrowers to more variables, and the numbers you reference define how often loan terms may change. Whether or not this type of loan makes sense for you depends on your ability to understand and manage those variables.



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